Margin Debt Poses Risky Situation

Your money

Rising Debt Is A Signal That The Bull Market May Be About To End, Market Watchers Say.

September 17, 1995|By New York Times

Burdened by debt? Consider this: Investors in America's stock markets were $66 billion in the hole to their brokers as of June 30.

That amount of margin debt, as it is called, is higher than it often has been. In June 1994, for instance, it was about $59 billion. But for many market watchers, the real concern is relative: the size of such debt compared with the value of stocks.

One concerned person is Hugh Johnson, chief investment officer of First Albany Corp. He said that margin loans, which are used primarily to buy stocks, have reached 1.25 percent of the total value of the equities listed on the New York Stock Exchange. Typically, the debt accounts for less than 1 percent of that value, he said.

To Johnson and others, such numbers are ominous. Although there are plenty of other indicators of the outlook for stocks, rising margin debt is ''one of the danger signals that we're getting near the end of the bull market,'' he warned.

History bears him out. Margin loans were nearing 1.5 percent just before the crash in October 1987, for example.

Andrew Engel, an analyst with the Leuthold Group, an investment research company in Minneapolis, explains that when margin debt first rises, Wall Street greets the development as good news. The growing loans mean that margin borrowers are feeling bullish about stocks.

But as margin debt continues to climb, Engel warned, the bullish sign turns bearish. It's not just that high debt levels often accompany peaking markets, he said. Also, margin borrowers themselves aggravate market declines by selling stocks in order to repay their loans, as they may need to do when stock values drop.

Margin buying's powerful lure is like cheap credit. Because the stockbroker has collateral for these loans - the securities or cash in the investor's margin account - the interest charged is a relatively low 8 percent to 11 percent.

These rates vary from broker to broker and are lower the greater the sum borrowed. And if the margin loan is used to purchase stocks rather than to pay for a car or college - for which they can also be used - the interest payments can be deducted from the taxes due on any investment profit.

But the chance for an outsize profit is the main lure of the margin loan. Consider Coram Healthcare, which provides health care to patients in their homes.

In July 1994, an investor could have bought 100 shares of Coram at $10 each, for a total of $1,000. If the investor had sold in January 1995, when those shares reached $20, he or she would have made a profit of $1,000 - a 100 percent return on the initial cash investment.

If the investor had used the $1,000 to buy Coram shares and also borrowed $1,000 to purchase more, though, the pot would have held 200 shares. After repaying the loan, the investor would have earned a profit of $2,000 after selling in January 1995. That's $2,000, or a 200 percent return, on the same $1,000 outlay, minus commissions and interest payments.

But because such leveraging can wallop investors with losses, too, there are strict limits on the practice. Under the rules of the Federal Reserve, investors must finance a margin account with at least $2,000 in cash or securities and can only borrow up to 50 percent of a stock's price, up to 70 percent to 75 percent of the price for many bonds, and up to 90 percent of the price of U.S. Treasuries.

Moreover, brokers raise their own hurdles to margin buying. It's good professional practice to assess seriously a person's wealth, investing sophistication and investment history before accepting a substantial margin request, said Jerry Tankersley of Prudential Securities.

One reason for such caution is the margin call. In margin loans, the purchased stock itself often serves as the collateral. If the stock falls significantly - typical broker rules use a 30 percent ''trigger'' on stocks bought half with debt - the broker will ask the investor for more cash to secure the loan, either from new money or from the sale of some of the stock.

And the broker can and does send this call even though the stock's value exceeds the amount of the loan.

For some market watchers, the best way to minimize the risk of margin loans is to avoid them altogether.